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Foolish Book Review: "Hedge Funds for Dummies"

An excellent overview of the complex hedge-fund industry.

Once a little-known corner of the market, hedge funds are growing increasingly mainstream, as billionaire managers such as Edward Lampert, Carl Icahn, and Steven Cohen become well-known names. It's also getting easier for the Average Joe to play hedge funds, with firms such as Fortress Investment Group (NYSE:FIG) going public amid considerable investor demand. Despite all the media coverage, misconceptions about the industry abound. Thankfully, Hedge Funds for Dummies has arrived to help investors at every level of experience better understand these complex investment vehicles.

Author Ann Logue is not a hedge-fund manager -- but that's probably a good thing, since she doesn't try to show off or get overly complex. She does have an MBA in Finance from the University of Chicago, and she's worked as an analyst for firms like Andrew Davidson & Co. and Volpe Brown Whelan & Company.

Logue's book is well-organized, kicking off with the industry's basic concepts and history before tackling more sophisticated topics. She even covers complex issues like the Arbitrage Pricing Theory, sprinkling her text with occasional equations.

According to Logue, a hedge fund "is a lightly regulated investment partnership that invests in a range of securities in an attempt to increase expected return while reducing risk." Hedge funds enjoy tremendous flexibility to invest in different types of asset classes, including stocks, bonds, real estate, currencies, and commodities. They're also free to use any type of investment approach: betting on mergers, shorting distressed companies, or using complex computer programs to find trading opportunities, to name just a few. Whatever the market's conditions, hedge-fund managers hope to find positive returns.

The hedge-fund industry has posted stunning growth in the last few years. HFR Industry Reports shows that hedge-fund assets surged from $456 billion in 1999 to $1.4 trillion by the end of 2006.

This growth has begun to change hedge funds' behavior. Most notably, they've begun using their newfound clout to engage in proxy fights and take over companies. Logue points to Carl Icahn's 3% investment in Time Warner (NYSE:TWX) to shake up the lagging company, and to Edward Lampert's restructuring of Sears Holdings (NASDAQ:SHLD).

Their actions may have changed, but most hedge funds' fee structures remain the same. A hedge-fund manager typically generates a 1.5% to 2% fee for the assets under management. These funds also charge "carried interest," which usually represents about 20% to 25% of the profits the fund generates.

Hedge funds have become a juicy business for Wall Street firms. The largest hedge-fund player is Motley Fool Income Investor pick JPMorgan Chase (NYSE:JPM), with $34 billion of hedge fund assets under management. (To take the top spot, the company only recently surpassed Goldman Sachs' (NYSE:GS) $32 billion asset base.)

In addition to describing the hedge fund industry's many dimensions, Logue also provides plenty of useful advice. Her tips cover due diligence on fund managers, evaluating fees and contract terms, understanding hedge funds' multitude of investment strategies, and learning how to spot risk factors. Amazingly, she does all this clearly and understandably.

Want to impress your friends with your knowledge of the hedge-fund industry? This book's title may say it's for dummies, but it's actually a great way to get smarter.

Fool contributor Tom Taulli, author of The Complete M&A Handbook, does not own shares mentioned in this article. He is currently ranked 1,590 out of 24,619 in CAPS. JPMorgan Chase is an Income Investor pick, while Time Warner is a Stock Advisor pick. The Motley Fool has a disclosure policy.